Small and Medium-Sized Enterprises Line of Credit Project (RRP SRI 49273)

Home , Bank of Ceylon, DFCC Bank, Nations Trust Bank, Sampath Bank, Seylan Bank

Third Additional Financing of Small and Medium-Sized Enterprises Line of Credit Project (RRP SRI 49273)

EVALUATION OF SMALL AND MEDIUM-SIZED ENTERPRISES LINE OF CREDIT PROJECT (2016–2019)

1. The Asian Development Bank’s (ADB’s) Small and Medium-sized Enterprises Line of Credit Project (Project) was approved in February 2016 to address the issue of limited access to finance faced by small and medium-sized enterprises (SMEs). Formal microenterprises who have legally registered businesses were part of the targeted beneficiaries and were mostly the participants of the Project. This note provides an assessment of the impact brought about by the Project to its 2,845 participants.

A. Rationale for the Project

2. SME finance gap. Despite financial outreach in terms of access to bank accounts, savings have not effectively channeled to productive investments in Sri Lanka. A study carried out by the International Finance Corporation revealed that the current credit supply to formal SMEs was $2.1 billion while $13.7 billion accounted for unmet demand, including $0.4 billion from women-led SMEs. In fact, 35% of the formal SMEs indicated fully constrained by finance and 31% indicated partly constrained. Furthermore, informal enterprises accounting for 73% of the formal firms demand $14.2 billion. Almost all SMEs require external financing given its limited internal capital for their business growth, but only few could access from the formal banking system. This financial constraint is more severe in Sri Lanka compared with other Asian countries in middle- income status (Table 1).

Table 1: Small and Medium-Sized Enterprises Finance Gap Firms Credit Number of SME Finance Gap Constrained Informal Enterprises ($ billion) (%) Country Informal % of Gap Number Current Potential Potential women- Full Partial Gap (Women- of SMEs Volume Demand Demand led led) ($ billion) Bangladesh 900,000 5.0 32 16 18.5 54.6 36.1 2.4 30.0 India 336,000 6.0 17 32 135.1 356.2 221.1 19.6 96.5 Malaysia 148,678 15.0 7 33 69.8 84.7 14.9 3.1 38.4 Sri Lanka 81,531 14.0 35 31 2.1 15.8 13.7 0.4 14.2 Thailand 2,646,549 57.9 31 23 111.1 … … … 142.9 SMEs = small and medium-sized enterprises. Source: International Finance Corporation. 2017. IFC Enterprise Finance Gap Survey.

3. The persistent SME financing gap in Sri Lanka is not entirely due to lack of liquidity in the banking sector. 25% of total bank lending in 2016 was towards the SMEs, but most SME loans were considered as collateralized and short-term.1 The banks have been reluctant to provide long- term financing to SMEs due to (i) high costs and risks relative to other market segments, (ii) a mismatch between the collateral required by banks and the collateral SMEs have, and (iii) SMEs’ capacity limitations in applying for and utilizing loans.

4. Against this backdrop, ADB’s Project has provided (i) a credit line to SMEs mainly for capital investments through 10 participating financial institutions (PFIs), 2 and (ii) attached

1 A. Wijesinha and N. Perera. 2015. Banking on SME Growth: Concepts, Challenges and Policy Options to Improve Access to Finance in Sri Lanka. Colombo: Institute of Policy Studies of Sri Lanka. 2 The 10 PFIs are Bank of Ceylon, Commercial Bank, DFCC Bank, Hatton National Bank, National Development Bank, Nations Trust Bank, People’s Bank, Regional Development Bank, Sampath Bank, and Seylan Bank. 2

technical assistance for capacity building of SMEs, banks, and the government. The expected project impacts for stakeholders were as follows:

(i) Economic benefits to SMEs. (a) Access to long-term credit enabling productive investments and (b) productive investments leading to larger sales and increased profits;

(ii) Economic benefit for banks. (a) Access to long-term funding enhancing PFIs’ lending capacity to new SME clients and (b) expanded SME customer base enabling portfolio diversification; and

(iii) Economic benefit for the government. (a) Increased company registrations leading to increased tax revenue and reduced social welfare burden, (b) increased SMEs’ outputs resulting in increased job opportunities and increased tax revenue contributing to fiscal position, and (c) enhanced financial intermediation through banking sector will enhance productive investments to non-SME sectors for economic growth and employment generation.

B. Progress of Project Implementation

5. The $100 million original loan was allocated from March 2016 to September 2017 through 4 semiannual allocations (1st–4th allocations). The $75 million additional loan was allocated from March 2018 to September 2019 through 4 semiannual allocations (5th–8th allocations).

6. Competitive fund allocation. The Project has an incentive mechanism in place to create competition among PFIs and achieve development targets in respect to SMEs who are constrained by limited access to finance. The Project has semiannual fund allocations for 10 PFIs. The fund allocations were made in end-March and end-September, which were disbursed to PFIs 3 months after the fund allocations (i.e., in early-July and early-January). From the disbursement date, the government starts to charge interest to PFIs on applicable disbursed amounts. PFIs must disburse 80% of their respective allocated amount while achieving development targets within 5 months from the previous fund allocation (i.e., in end-August and end-February) to be eligible for the next fund allocation that will be held in the succeeding month.

1. Original Loan

7. The original development targets were set for lending to first-time borrowers, women-led, and targeted SMEs as follows:

(i) 10% of the number of subloans to first-time borrowers from a licensed commercial or specialized bank;

(ii) 5% of the number of subloans to SMEs led by women; and

(iii) 50% of the amount of subloans lent cumulatively to targeted SMEs, which include SMEs that are (a) located outside of Colombo District, (b) borrowing for non- collateral working capital, (c) led by women, or (d) first-time borrowers from a licensed commercial or specialized banks.

8. The first and second allocations of $12.5 million each (equivalent in local currency) were carried out through an auction mechanism, in which each PFIs indicated their borrowing amount 3

and interest rate. Those PFIs who indicated higher interest rates were prioritized when allocating the ADB funds.3 The key objectives of the auction mechanism were (i) allocating more funds to more motivated PFIs for SME lending and (ii) ensuring sufficient credit margins for PFIs while achieving lower lending rates to SMEs who do not want to borrow at high interest rates.

9. In the first allocation/auction, National Development Bank took a full amount of $12.5 million at 6.01% while the 6-month average weighted deposit rate (AWDR) was at 6.23%. Since the domination by one bank might be less effective for achieving financial outreach, the government and ADB agreed to cap the amount any bank could win to a third of available funds and ensure at least three PFIs would win from the second auction. In the second allocation/auction, DFCC Bank won $4.13 million at 11.01%, Hatton National Bank won $4.13 million at 8.60%, and Sampath Bank won $4.13 million at 8.25% while the AWDR was 7.03%. The second auction showed the risk of aggressive bidding where some banks may speculate the interest rate hike and bid a higher interest rate, which would lead to a higher lending rate to SMEs. Sampath Bank could not achieve the targets within 5 months from the fund allocation and was not eligible for the third allocation.

10. Based on these two experiments, the government and ADB decided to revert to a conventional pro-rata fund allocation system at the AWDR from the third allocation. Furthermore, the development targets were raised as in Table 2 given these new targets were considered as ambitious but feasible based on the results of the first and second allocations. To invite more PFIs, the semiannual allocation amount was increased from $12.5 million to $37.5 million.

Table 2: Revisions of Development Targets 1st and 2nd Allocations 3rd–8th Allocations Development Target Requirements Results Requirements First-time borrowers (number) 10% 25.6% 20% Women-led (number) 5% 17.5% 20% Targeted SMEs (amount) 50% 89.5% 70% SMEs = small and medium-sized enterprises.

11. The third and fourth allocations of $37.5 million each were fully subscribed by eligible PFIs.4 Seylan Bank failed to achieve the targets under the third allocation, and People’s Bank and Nations Trust Bank failed under the fourth allocation.

2. Additional Loan and We-Fi grant

12. The $75 million additional loan was approved in January 2018 and was topped up from the fifth allocation in end-March 2018. The $75 million additional loan was originally planned to be allocated through 3 semiannual allocations of $25 million equivalent each. The disbursement targets were retained.

13. The $9.5 million grant from the Women Entrepreneurs Finance Initiative (We-Fi) was approved in June 2018 to cover a 20%–35% of subloan principal for eligible women-led SMEs.

3 For example, give the total allocated amount is $12.5 million, if institution X bids $3 million at 10%, institution Y bids $8 million at 8%, and institution Z bids $12 million at 6%, then X would receive $3 million at 10%, Y would receive $8 million at 8%, and Z would receive $1.5 million at 6%. 4 Sampath Bank failed to achieve targets under the second allocation. Seylan Bank failed to achieve the targets under the third allocation, and People’s Bank and Nations Trust Bank (NTB) failed under the fourth allocation. During the fifth allocation period, Seylan Bank failed to achieve the targets and NTB could not restore the eligibility during the fifth allocation period. 4

The We-Fi grant was subscribed at $1.23 million for the fifth allocation and at $1.79 million for the sixth allocation. To provide more time for PFIs to find out eligible women-led SMEs, the government and ADB decided to split the remaining $25 million loan into 2 equal semiannual allocations—seventh and eighth allocations. Consequently, $1.55 million We-Fi grant was allocated in the seventh allocation and $1.98 million in the eighth allocation.

14. Satisfactory implementation progress. The Project demonstrated quick disbursement and encouraged banks to reach out to underserved SMEs and achieve development targets. The $100 million original loan was fully onlent to 1,755 eligible SMEs, out of which 27.6% were women- led and 26.8% had never borrowed from formal banks (first-time borrowers). 91.4% of the loans were provided to targeted SMEs, such as those located outside of Colombo district. The momentum for supporting underserved SMEs has been continuing for the additional loan and We-Fi grant since August 2018. As of 29 February 2020, $75 million was fully subscribed by the PFIs and $71.9 million was onlent to 1,739 SMEs, out of which 47.2% were women-led and 27.0% were first-time borrowers. With this, 93.3% of the loan was provided to the targeted SMEs. The significant increase in women-led SME subborrowers was attributed to the We-Fi grant provisions. Out of the $9.5 million available fund, $6.15 million We-Fi grant was provided to 637 women-led SMEs.

C. Detailed Data Analysis

15. A detailed subloan data set was constructed using data provided by PFIs. The most recent data was as of 30 June 2019, which captures a total of 2,845 subloans under the 1st–6th allocations of $150 million, 87.2% of the $171.9 million has been onlent as of 29 February 2020. This section will provide a detailed analysis on the impact of the ADB’s SME Line of Credit Project (including We-Fi grant).

16. Table 3 shows that there is no significant difference in the financial terms and conditions (tenure, interest margin and equity contribution) across micro, small and medium-sized segments.

Table 3: Summary Statistics (1st–6th Allocation, Cross Section) Enterprise Type Micro Small Medium Total Subloans (number) 1,879 760 185 2,845 (66.1%) (26.8%) (6.5%) (100.0%) Total Subloan Value (SLRs million) 8,664 10,420 4,411 23,861 (36.3%) (43.7%) (18.5%) (100.0%) Subloan Size (SLRs million) 4.63 13.69 23.71 - Subloan Tenure (months) 62.5 65.1 64.9 - Interest Margin (%) 3.75 3.75 3.59 - % of equity contribution 32.0 35.0 36.0 - Annual Turnover (SLRs million) 30.07 120.3 256.5 198,541 Employees (number) 4.4 22.6 107 47,692 Note: Out of 2,845 subloans, 21 did not provide the data on the number of employees.

17. It should be noted that Regional Development Bank (RDB) provided 890 subloans (31.3%) and Bank of Ceylon (BOC) provided 511 subloans (17.9%) to micro-business segments due to their wide presence in rural areas and mandate of serving micro-businesses. Given the two state banks’ dominance, the average figures tend to reflect these two banks’ performance. Thus, the analyses in the following sections try to decompose the data by type of banks.

Table 4: Summary Statistics (First–Sixth Allocation, Time Series) 1st 2nd 3rd 4th 5th 6th Allocation (16 Apr– (16 Oct– (17 Apr– (17 Oct– (18 Apr– (18 Oct– Total 16Sep) 17 Mar) 17 Sep) 18 Mar) 18 Sep) 19 Mar) Allocation method Auction Auction Conventional Conventional Conventional Conventional Eligible PFIs 1 3 9 9 8 8 10 Loan allocated amount $12.50 $12.50 $37.50 $37.50 $25.00 $25.00 $150.00 ($ million) Loan provision 1,821 1,874 5,812 5,783 4,008 4,365 23,861 (SLRs million) Loan provision (number) 160 132 768 695 516 574 2,845 - Women-led SMEs 38 33 199 214 211 246 941 (23.8%) (25.0%) (25.9%) (30.8%) (40.9%) (42.9%) (33.1%) - First-time 35 19 221 196 141 192 804 Borrowers SMEs (21.9%) (14.4%) (28.8%) (28.2%) (27.3%) (33.4%) (28.3%) - Non-collateral 0 3 98 20 53 22 196 working capital (0.0%) (2.3%) (12.8%) (2.9%) (10.3%) (3.8%) (6.9%) - Colombo District 38 18 74 64 53 43 290 (23.7%) (13.6%) (9.6%) (9.2%) (10.2%) (7.4%) (10.2%) Grant allocated amount - - - - $1.23 $1.79 $3.02 ($ million) Grant provision - - - - 197.0 298.6 495.6 (SLRs million) Grant provision (number) - - - - 149 190 339 Average original subloan 11.38 14.19 7.56 8.32 8.14 7.60 8.38 principala (SLRs million) PFI = participating financial institution, SLRs = Sri Lankan rupee, SMEs = small and medium-sized enterprises. a The original subloan principal is a sum of ADB’s subloan and We-Fi grant.

1. SME Beneficiaries

18. SME definition. The definition and classification of SMEs were established in the National Policy Framework for SME Development in 2016, which was also adopted by the Central Bank of Sri Lanka (Table 5).5 It should be noted that an SME is an enterprise which has (i) less than 300 employees for the manufacturing sector and less than 200 employees for the service sector, and (ii) an annual turnover not exceeding SLRs750 million. Therefore, microenterprises are also part of SMEs. An enterprise falling under more than one category should be categorized based on the level of employment. Consequently, the classification within SMEs depends on the number of employees.

Table 5: National Small and Medium-Sized Enterprises Definition and Classification Item Criteria Medium Small Microa Annual Not exceeding SLRs750 More than SLRs15 Not exceeding SLRs15 Turnover million million and not million Manufacturing exceeding SLRs250 Sector million No. of 51–300 11–50 1–10 Employees Annual Not exceeding SLRs750 More than SLRs15 Not exceeding SLRs15 Turnover million million and not million Service Sector exceeding SLRs250 million

5 Government of Sri Lanka, Ministry of Industry and Commerce. 2016. National Policy Framework for Small Medium Enterprise Development. Colombo; Central Bank of Sri Lanka, Bank Supervision Department. 2017. Implementation of Budget Proposals 2017 in Respect of Banking Service. Colombo. 6

Item Criteria Medium Small Microa No. of 51–200 11–50 1–10 Employees SLRs = Sri Lanka rupee. a The national classification has a gap between small and micro. In the above table, micro was defined to include an enterprise that has annual turnover of 15 million or has 10 employees.

19. As per the national definition and classification, Table 6 shows the distribution of 2,845 SME subborrowers based on the data (annual turnover and number of employees) submitted by PFIs. 1,238 microenterprises (43.5%) were micro-scale businesses (Micro-T) given that those enterprises do not have more than 10 employees and with an annual turnover of not exceeding SLRs15 million. Their average subloan size is also quite small at SLRs2.7 million.

Table 6: Profile of Small and Medium-Sized Enterprises Subborrowers Number of Employees (National Classification) Not Item Medium Small Micro Available Totalb Medium 80 109 39 1 229 Small 96 531 585 3 1,215 Turnover Micro 8 108 1,238 9 1,363 Not Availablea 1 12 17 1 31 Totalb 185 760 1,879 17 2,838 a Out of 31 subloans where the data on annual turnover of subborrower was not available, 16 subloans were to first- time borrowers. b Seven irregular reporting on subloans (falling outside of SME definition on annual turnover and number of employees were excluded.

20. There are outliers in micro and medium-sized segments as per number of employees (i.e., the national classification) in terms of annual turnover. Among 1,880 microenterprises, 39 have large annual turnovers which fall in the indicative range for medium-sized enterprises (exceeding SLRs250 million). Among 186 medium-sized borrowers, 8 have small annual turnover which fall in the indicative range for micro-sized enterprises. By excluding these outliers, the average subloan size and annual turnover are significantly adjusted as in Table 7.6

Table 7: Data Adjustment (SLRs million) Item Micro Small Medium Original: Subloan Size 4.63 13.69 23.71 Annual Turnover 30.07 120.30 256.50 Revised: Subloan Size 4.32 13.69 23.99 Annual Turnover 21.30 120.30 267.80

21. Out of 2,845 subloans, 66% were concentrated among microenterprises. However, in terms of the amount of credit provision, ADB’s credit line was distributed in a balanced manner among micro- (37%), small- (44%) and medium-sized enterprises (19%) (Figure 1 and Table 8). This indicates that ADB’s credit line improved access to finance in all segments.

6 Even after the exclusion of the outliers with large annual turnover, the average annual turnover of microenterprises is SLRs21.3 million, which is within an indicative range of small-sized enterprises. 7

Figure 1: Small and Medium-Sized Enterprises Types by Subloan Number and Value Number Value

7% 19% 37% 27%

66% 44%

micro small medium micro small medium

Table 8: Subloan Distributions by Subloan Size Total V1 V2 V3 V4 V5 V6 V7 V8 < SLRs SLRs SLRs SLRs SLRs SLRs SLRs SLRs 0.75m 0.75m < 1.5m < 2.5m < 5.0m < 10.0m < 20.0m < 30.0m < 2,845 247 564 374 599 417 317 179 148 Number (100.0%) (8.7%) (19.8%) (13.1%) (21.1%) (14.7%) (11.1%) (6.3%) (5.2%) 1,295 223 436 225 253 98 40 11 9 - Micro-L (45.5%) (7.8%) (15.3%) (7.9%) (8.9%) (3.4%) (1.4%) (0.4%) (0.3%) 584 18 88 94 157 109 68 33 17 - Micro-H (20.5%) (0.6%) (15.3%) (7.9%) (8.9%) (3.4%) (1.4%) (0.4%) (0.3%) 760 3 38 48 171 182 163 82 73 - Small (26.7%) (0.6%) (3.1%) (3.3%) (5.5%) (3.8%) (2.4%) (1.2%) (0.6%) 185 0 1 6 16 23 45 49 45 - Medium (6.5%) (0.0%) (0.0%) (0.2%) (0.6%) (0.8%) (1.6%) (1.7%) (1.6%) Amount 23,862 109 629 790 2,416 3,458 5,013 4,689 6,757 (SLRs) (100.0%) (0.5%) (2.6%) (3.3%) (10.1%) (14.5%) (21.0%) (19.7%) (28.3%) Note: Breakdown data by SME category excludes 21 subloan data that have unavailable information on the number of employees.

22. Significance of ADB’s loan. After removing the outliers, the subloans under ADB’s credit line accounted for a large portion of the annual turnover for the smaller enterprises (Table 9). The lower-end of micro-sized enterprises (Micro-L) employing five or less borrowed on average 2.53 months of turnover. Higher-end microenterprises (Micro-H) and small enterprises borrowed around 1.4 months of turnover, and medium-sized enterprises borrowed 1.07 months of turnover. This indicates that Micro-L segment took more business risk with ADB’s credit line and banks also faced high credit risk.

23. It should also be noted the 1,238 businesses in the Micro-T segment (with 1-10 employees and with annual turnover of not exceeding SLRs15 million) borrowed on average 5.53 months of turnover. ADB’s credit line has significant impacts on their business growth and the transitional support for the Micro-T segment to the Small segment should be promoted for efficient economic resource allocation.

Table 9: Business Profile of Different Small and Medium-sized Enterprises Segments Micro-T (1-10 employees and Micro-L Micro-H Small Medium annual turnover of (1-5 (6-10 (11-50 (51-200/300 Item SLRs15 million or less) employees) employees) employees) employees) Number of Subloans 1,239 1,276 548 761 177 Subloan Size 2.70 3.09 4.32 13.69 23.99 (SLRs million) Annual Turnover 5.85 14.64 36.92 120.29 267.79 Number of Employees 3.6 2.9 7.8 22.6 107.6 Productivity (Annual 1.63 5.04 4.73 5.32 2.48 Turnover SLRs/employee) Subloan-size / 5.53 2.53 1.40 1.37 1.07 Monthly Turnover

24. State-owned banks have driven financial inclusion by catering to microenterprises. Subloan data in Table 10 clearly shows that the profile of subborrowers shifted to micro and small segments from the third allocation when (i) the allocation was reverted to the conventional method to invite more PFIs and (ii) development targets were raised. State-owned banks, in particular RDB and BOC have proactively achieved these development targets by catering to the micro segment. While the average loan size for private sector banks have been stable, three state- banks focused more on micro and small segments from the beginning of their participation in the ADB credit line. BOC has sharply increased their lending to women-led microenterprises with We- Fi grant from the fifth allocation onwards. Although private sector banks increased their lending to women-led SMEs from the sixth allocation, they continued to cater mostly to small-sized enterprises.

Table 10: Average Subloan Size by Bank Type 1st 2nd 3rd 4th 5th 6th (16 Apr– (16 Oct– (17 Apr– (17 Oct– (18 Apr– (18 Oct– Allocation 16 Sep) 17 Mar) 17 Sep) 18 Mar) 18 Sep) 19 Mar) Total All PFIs 11.38 14.19 7.56 8.32 8.14 7.60 8.38 - Private sector banks 11.38 14.19 13.02 15.20 14.61 18.58 14.42 - People’s Bank … … 6.27 8.65 … 5.18 6.89 - Bank of Ceylon … … 5.20 6.28 4.17 3.70 4.70 - RDB … … 2.63 2.41 2.74 2.35 2.52 PFI = participating financial institution, RDB = Regional Development Bank.

25. RDB and BOC reached out to smaller business segments, especially women-led and first- time borrowers, whereas private sector banks catered to large-sized women-led SMEs (Table 11).

Table 11: Average Subloan Size by Targeted Small and Medium-sized Enterprises All SMEs Women-led First-Time Borrower Item (SLRs million) (SLRs million) (SLRs million) RDB 2.52 1.95 1.67 BOC 4.70 3.56 3.28 People’s Bank and Private sector banks 13.30 13.64 12.46 TOTAL 8.39 7.62 7.00 BOC = Bank of Ceylon, RDB = Regional Development Bank, SLR = Sri Lankan rupee, SMEs = small and medium- sized enterprises.

26. Location. Beneficiaries are widely scattered across the country. Colombo district accounted for only 15% of the total amount of subloans under the third to sixth allocation. Private sector banks have proactively supported more SME subprojects in extremely economically 9

lagging Northern and Eastern Provinces while they also supported those in relatively affluent Western and North Western Provinces. This reflects higher average loan sizes in these regions.

Table 12: Geographical Distribution of Subloans (Third–Sixth Allocations) Average # of Loans Amount of Loans Loan Size SLRs SLRs # of Loans Share Share million million BOC, Private Total % Total % Average RDB, PB Banks Western 824 427 397 32 8,332 41 10.11 - Colombo 234 94 140 9 3,091 15 13.21 Central 299 250 49 12 1,458 7 4.88 Southern 590 405 185 23 3,862 19 6.55 North Western 196 100 96 8 2,075 10 10.59 North Central 146 108 38 6 1,071 5 7.34 Northern 57 7 50 2 613 3 10.75 Eastern 59 27 32 2 504 2 8.54 Sabaragamuwa 168 128 40 7 1,027 5 6.11 Uva 214 166 48 8 1,223 6 5.71 Lagging Regionsa 498 328 170 20 3,367 17 6.76 Total 2,553 1,618 935 100 20,165 100 7.90 BOC = Bank of Ceylon, PB = People’s Bank, RDB = Regional Development Bank, SLR = Sri Lankan rupee, SMEs = small and medium-sized enterprises. a Lagging regions include Northern, Eastern, Sabaragamuwa and Uva.

27. Sectoral distribution. The sectoral data has been compiled based on the subloan data submitted by PFIs (Table 13-A).7 SME beneficiaries are fairly distributed across a wide range of different sectors that mirrors the industrial structure of Sri Lanka. Manufacturing, including mining (25.7%), wholesale and retail trade (21.1%), agriculture, forestry and fishing (14.4%), and tourism and restaurants (14.0%) accompanied a large share of ADB lending. Average loan size was larger in construction, tourism and education sectors, while agriculture, professional Services and information and communication technology sectors had a smaller loan size.

Table 13-A: Sectoral Distribution of Subloans (Third–Sixth Allocation) Average # of Loans Amount of Loans Loan Size # of Share (SLRs Share (SLRs Sector Loans (%) million) (%) million) Construction 100 3.9 1,027.5 5.1 10.27 Wholesale and Retail Trade 545 21.3 4,278.0 21.3 7.85 Manufacturinga 604 23.7 4,104.6 20.5 6.80 Agriculture, Forestry and Fishingb 387 15.2 2,304.4 11.5 5.95 Health Care, Social Services and 177 6.9 1,326.6 6.6 7.50 Support Services Tourismc 359 14.1 3,988.5 19.9 11.11 Transportation and Storaged 110 4.3 919.3 4.6 8.36 ICT 36 1.4 233.6 1.2 6.49 Education 63 2.5 780.1 3.9 12.38 Professional, Scientific and Technical Activities 41 1.6 135.2 0.7 3.30 Arts, Entertainment and Recreation 26 1.0 85.2 0.4 3.28 Otherse 105 4.1 882.4 4.4 8.40 Total 2,553 100.0 20,065.4 100.0 7.86

7 It should be noted that ADB classified subloans into sectoral categories as in Table 13 based on the subloan information on (a) sector and (b) type of activities that was submitted by PFIs given different PFIs apply different approach to sectoral categorization of subloans. 10

ICT = information and communication technology, SLR = Sri Lankan rupee. a Manufacturing includes mining and gem industries, auto-repair, engineering work, printing, and grinding mills (unspecified). b Agriculture, forestry and fishing includes floriculture, livestock and dairy, ornamental fish, processed food and beverages. c Tourism includes restaurants. d Transportation and storage includes filling stations and service stations. e Others include service subsectors that do not fall into the other categories, including electricity and gas supply, leasing and rental business, and data not available.

28. Agriculture, forestry and fishing sector. As in Table 13-B, the agriculture, forestry and fishing sector covers the activities related to agriculture, forestry, fishing, livestock and dairy, ornamental fish processed food and beverages. Tea factories (SLRs422.0 million for 21 subloans), fisheries (SLRs421.4 million for 110 subloans) and rice mills (SLRs251.9 million for 37 subloans) were key beneficiaries.

Table 13-B: Breakdown of Agriculture, Forestry and Fishing Sector # of Loans Amount of Loans Average Loan Size # of Share (SLRs Share (SLRs Sector Loans (%) million) (%) million) Agriculture (including Floriculture) 39 10.1 90.7 3.9 2.33 Agro Processinga 121 31.3 1,136.2 49.3 9.39 Beverages 4 1.0 16.4 0.7 4.10 Fisheries 110 28.4 421.4 18.3 3.83 Livestock and Dairy 30 7.8 235.7 10.2 7.86 Ornamental Fish 11 2.8 72.5 3.1 6.59 Processed Foodb 72 18.6 331.6 14.4 4.61 Total 387 100.0 2,304.4 100.0 5.95 SLR = Sri Lankan rupee. a SLRs422.0 million (21 subloans) are for tea factories and SLRs251.9 million (37 subloans) are for rice mills, SLRs224.2 million (26 subloans) are for other minor crops (cane, cashew, cinnamon, mushroom, pepper, ginner, sesame, and other spices), and SLRs236.6 million (36 subloans) are data not available. b SLRs121.8 million (30 subloans) are related to bakery production.

29. Manufacturing Sectors. The manufacturing sector covers activities related to non- agricultural/food manufacturing and engineering work. While a wide range of manufacturing businesses were financed, key beneficiaries were (i) apparel and garments (SLRs770.6 million for 216 subloans); (ii) painting and printing (SLRs448.1 million for 36 subloans); (iii) carpentry, furniture and lathe work (SLRs340.5 million for 68 subloans); and (iv) mining and jewelry (SLRs277.5 million for 20 subloans).8

30. Service Sectors. The tourism sector covers activities related to hotels, restaurants and tourism. While breakdowns were not available, it is expected that many subprojects were for construction of hotels or restaurants.9 The healthcare, information and communication technology, education and professional, and art sectors cumulatively accounted for 343 subloans (13.4% to the total) and SLRs2,560.7 million (12.8% to the total). The transportation and storage sector (SLRs919.3 million for 110 subloans) covers activities related to automobile related services, logistics and storage businesses, which include auto service stations/filling stations (SLRs472.5 million for 60 subloans). The other sector (SLRs882.4 million for 105 subloans) includes leasing

8 Manufacturing sector includes auto repairs of SLRs99.7 million (10 subloans) and grinding mills of SLRs62.8 million (8 subloans). 9 Environmental Category-B subprojects account for 16.7% of subloans in tourism sector, which is higher than the overall average of 7.4% in all the sectors. 11

and rental business (SLRs280.2 million for 18 subloans), but most of the subloans data in this category were not available.

2. Financial Terms and Conditions

31. From the third allocation, the PFIs borrowed at average weighted deposit rates (AWDR) at the time of fund allocation. Table 14 is a summary of financial terms and conditions of subloans.

Table 14: Summary of Financial Terms and Conditions (Third–Sixth Allocation) 1st 2nd 3rd 4th 5th 6th (16 Apr– (16 Oct– (17 Apr– (17 Oct– (18 Apr– (18 Oct– Allocation 16 Sep) 17 Mar) 17 Sep) 18 Mar) 18 Sep) 19 Mar) Funding Cost (%) 6.01 9.29 8.10 9.04 9.05 8.66 Average Upfront Fee (%) 0.91 0.27 0.64 0.64 0.60 0.64 Interest Margin (%) - average 5.07 3.33 3.78 3.58 3.60 3.73 - range (all) 3.00– 2.49– 2.00– 2.46– 2.45– 2.34– 7.49 5.74 6.90 5.96 5.96 8.66 Average Tenor (months) 57.2 67.2 63.0 63.8 64.9 66.3

Interest Margin (%) - Bank of Ceylon … … 2.99 3.00 2.99 3.38 - RDB … … 4.00 4.00 4.00 4.00 - Private Banks (average) 5.07 3.33 4.29 3.48 3.36 3.77 - CBC … … 4.01 3.68 3.71 3.57 - HNB … 2.85 3.57 2.59 2.56 2.98 - DFCC … 3.33 4.62 3.66 3.49 4.41 - NDB 5.07 … 4.83 3.84 4.00 4.67 - Sampath … 3.75 … 3.53 2.99 3.34 Spread between AWPLR and AWDR 1.57 3.81 3.45 2.59 3.18 2.63 Spread between AWLR and AWDR 5.22 5.85 5.09 4.72 4.96 5.47 AWDR = average weighted deposit rate, AWPLR = average weighted prime lending rate, CBC = Commercial bank of Ceylon, HNB = Hatton National Bank, NDB = National Development Bank, RDB = Regional Development Bank.

32. Interest Margin. As in Figure 2, the PFIs’ interest margin was around 3%–4%, which enabled a final onlending rate to be comparable with average weighted prime lending rate plus 0.5%–1%. The average interest margin for investment subloans was 3.73% while that for working capital was 3.45%. The average interest margin was sticky for the two state-owned banks, BOC and RDB as they applied a single credit margin to all the SME subloans regardless of the size or tenure. Private sector banks had also applied a single credit margin to most of the subborrowers but with some adjustments depending on the subborrower’s profile. Also, their level of the credit margin has been dynamically adjusted in accordance with the market conditions—its onlending rate was set around in the mid-point between average weighted prime lending rate and average weighted lending rate (AWLR). Banks did not charge a high credit margin. Convergence of the onlending rates among private sector banks indicates that the competition among these banks for the small enterprise segment would have driven down the interest margin.

33. Tenure. As in Figure 2, the average tenure of the 2,845 subloans was 63.5 months. 1,832 subloans (64.4%) were between 60 months (5 years) and 84 months (7 years), and 338 subloans (11.8%) were beyond 7 years, which was uncommon. There was no significant difference among the 10 PFIs in the average and distribution of tenures. All PFIs utilized ADB’s credit line providing long-term financing for capital investments. Out of 652 subprojects, the average tenure was extended from 55.7 months in the previous loan (before ADB’s credit line) to 64.1 months in the 12

ongoing loan under ADB’s credit line. The average tenure of working capital subloans was 25.6 months.

Figure 2: Credit Margin and Tenure of Subloans Credit Margin Distribution of Subloan Tenure (from 3rd allocation) (months) 6.5 700 600 500 400 300 200 100 1.5 0

BOC RDB RDB BOC PB + Private Private Banks

34. Collateral. Subloans data on collateral types was collected from the third allocation. Out of 2,553 subloans, 2,302 subloans (90.2%) were investment loans. Out of the investment loans, 1,501 loans (65.2%) were collateralized with real estates. The average collateral value (SLRs20.5 million) was about twice as large as the average subloan size (SLRs9.9 million) in the case of collateralized loan with real estate. RDB and BOC were somewhat flexible in accepting personal guarantee in lieu of collateral. It should be noted that around half of the non-collateral working capital loans were provided by BOC. A detailed summary is in Table 15.

Table 15: Collateral Arrangements for Subloans (Third–Sixth Allocation) Working Capital Investment Loan Private + Private + All RDB BOC All RDB BOC PB PB Collateral 34 16 11 7 1,502 795 502 205 (Real Estate) (13.6%) (14.8%) (73.3%) (5.5%) (65.2%) (76.1%) (57.4%) (53.4%) Collateral 2 2 0 0 23 23 0 0 (Financial Asset) (0.8%) (1.9%) (0.0%) (0.0%) (1.0%) (2.2%) (0.0%) (0.0%) Collateral (Movable 7 5 0 2 282 124 79 79 equipment Asset and (2.8%) (4.6%) (0.0%) (1.6%) (12.2%) (11.9%) (9.0%) (20.6%) Inventories) Collateral 0 0 0 0 44 42 2 0 (not available) (0.0%) (0.0%) (0.0%) (0.0%) (1.9%) (4.0%) (0.2%) (0.0%) Non-Collateral with 162 40 4 118 388 39 260 89 personal guarantee (64.8%) (37.0%) (26.7%) (92.9%) (16.8%) (3.7%) (29.7%) (23.2%) Non-Collateral only 4 4 0 0 59 16 32 11 (1.6%) (3.6%) (0.0%) (0.0%) (2.6%) (1.5%) (3.7%) (2.9%) Non-collateral 41 41 0 0 5 5 0 0 (not available) (16.4%) (40.0%) (0.0%) (0.0%) (0.2%) (0.5%) (0.0%) (0.0%) Total 250 108 15 127 2,303 1,044 875 384 (100.0%) (100.0%) (100.0%) (100.0%) (100.0%) (100.0%) (100.0%) (100.0%) BOC = Bank of Ceylon, PB = People’s Bank, RDB = Regional Development Bank. Note: One loan is not categorized either working capital or investment loan.

35. Equity contribution. There is no significant difference in the level of equity contribution in terms of the existence of We-Fi Grant and collateral arrangements as in Table 16.

Table 16: Equity Contribution (Third–Sixth Allocation) (%) Without We-Fi Grant With We-Fi Grant Collateralized Non-collateralized Collateralized Non-collateralized Micro-L 31.0 31.3 31.4 27.3 Micro-H 34.5 29.0 35.7 26.7 Small 35.0 33.6 34.6 32.1* Medium 36.8 36.2* 38.4* 40.3* Note: * indicates that a sample size is smaller than 20 and thus these summary statics are considered not robust.

3. Banking Sector Performance

36. 10 PFIs have expanded their SME operations while retaining the asset quality of the subloans under ADB’s credit line.

37. SME loan portfolio growth. 10 PFIs have increased their SME portfolio during 2016– 2018 as in Table 17. Please note that, since different PFIs apply different SME definitions, cross- sectional comparisons do not draw any meaningful conclusion.

Table 17: Small and Medium-sized Enterprises Loan Portfolio Growth (2015–2019) Item BOC PB CBC Hatton Sampath Seylan NDB NTB DFCC RDB June 2019 Total loans 1,409.5 1,181.9 881.0 724.9 659.7 343.9 372.4 231.2 265.9 132.2 and advances (SLRs billion) SME loans NA 12.4 173.9 207.9 96.9 98.0 82.8 66.8 91.7 31.1 and advances (SLRs billion) SME Loan / NA 1.0% 19.7% 28.7% 14.7% 28.5% 22.2% 28.9% 34.5% 23.5% Total Loan FY2015 Total loans 826.8 768.5 478.5 498.3 377.3 193.1 215.1 120.3 73.9 88.4 and advances (SLRs billion) SME loans 11.9 11.3 111.9 129.4 NA 58.3 29.8 27.4 41.4 9.4 and advances (SLRs billion) SME Loan / 1.4% 1.5% 23.4% 26.0% NA 30.2% 13.9% 22.8% 56.0% 10.6% Total Loan BOC = Bank of Ceylon, CBC = Commercial Bank of Ceylon, NDB = National Development Bank, NTB = Nations Trust Bank, PB = People’s Bank, RDB = Regional Development Bank Source: ADB staff estimates based on submitted data by 10 PFIs.

38. Asset quality. Banking sector asset quality deteriorated in 2019 with an increase of non- performing loan (NPL) ratio. The banking sector NPL ratio increased from 3.4% in December 2018 to 4.7% by December 2019. A rise in NPL was observed across all economic sectors, with marked increase in agriculture and tourism sectors. However, the NPL ratios of ADB’s credit line project were well below the banking sector NPL ratio. It was 1.1% as at August 2018 and was up to 2.2% as of August 2019. This indicates that PFIs’ credit risk management of SME loans is prudent.

Table 18: NPL Ratio of SME LoC Portfolio by PFI (%)

Item BOC PB CBC Hatton Sampath Seylan NDB NTB DFCC RDB Total SME LoC: May 2017 N/A N/A N/A 0.00 0.00 N/A 4.37 N/A 0.00 N/A 4.37 August 2017 0.00 0.00 0.00% 0.00 0.00 0.00 4.01 0.00 0.00 0.00 4.01 February 2018 0.03 0.00 0.00% 0.00 0.00 0.00 3.01 0.00 0.00 2.29 0.90 August 2018 0.07 4.11 0.00% 0.00 0.00 0.00 2.81 4.69 0.21 2.65 1.41 February 2019 0.13 3.29 0.71% 0.00 0.00 0.00 4.08 1.56 0.41 4.20 1.47 August 2019 0.23 3.55 0.33% 0.86 0.94 0.56 6.12 3.09 0.54 3.90 2.22 Entity Level: FY 2017 0.80 0.72 0.22% 0.77 0.75 4.10 1.39 2.52 0.77 1.73 NA FY 2018 1.00 1.36 1.71% 1.11 2.39 4.42 1.98 2.13 1.20 2.78 NA BOC = Bank of Ceylon, CBC = Commercial Bank of Ceylon, NDB = National Development Bank, NTB = Nations Trust Bank, PB = People’s Bank, RDB = Regional Development Bank Source: Project reports (unaudited) and entity-level financial statements (audited) by 10 PFIs.

D. Economic Analysis

39. Government margin. The government will take foreign exchange rate risk and credit risk of PFIs by charging the difference between AWDR and their borrowing rate from ADB’s ordinary capital resources (i.e., LIBOR plus 0.5%). As in Table 18, the government margin is at 5.9% on average during 2016–2019. This is considered sufficient to cover the foreign exchange risk and credit risk of the 10 PFIs.10

Table 19: Development of Government Margins (%) Item 2016 2017 2018 2019 Average ADB’s OCR Loan Interest rate 1.6 2.0 3.0 2.8 2.4 6 months AWDR 6.7 8.7 8.9 8.8 8.3 Government Margin 5.1 6.7 5.9 6.0 5.9 ADB = Asian Development Bank, AWDR = average weighted deposit rate, OCR = ordinary capital resources. Source: ADB staff estimates.

40. Economic benefit for SMEs. While the expected long-term economic impact is difficult to quantify, the project’s expected direct benefits were estimated based on the initial findings from a sample of 240 SME beneficiaries that were randomly selected from the ongoing credit line provided in April 2017–March 2018 (third and fourth allocations).11 Out of 240 sample SMEs, 216 provided complete business data as of March 2019. The average loan size was SLRs6.2 million. Out of 216, 135 are micro (62.5%), 69 are small (31.9%) and 12 are medium-sized (5.5%).

41. The survey results are in Table 20. It should be noted that there is a time-lag for new businesses to show increasing profits as the enterprise undergoes a J-curve effect with the gradual achievement of operational efficiency, better access to market; and is also dependent on macroeconomic conditions and competitive environment. Although it is too early to validate the economic impact with this sample over a short evaluation period, the business results emanating from the sample indicate positive impact on business performance amidst a difficult macroeconomic environment in 2018 and 2019.

10 Annual depreciation rates of Sri Lankan rupee to US dollar were 7.1% in 2016–2019, 4.1% in 2013–2016 and 4.5% in 2010–2012. The average Inflation rate differential over the last decade between Sri Lanka and the United States was 3.4% (the average annual inflation rate in the US was 1.77% while that in Sri Lanka was 5.17%). 11 Out of 10 PFIs, Sampath and Seylan were excluded given they only participated one of the two fund allocations. 30 subprojects were selected from each of the other eight PFIs. 15

Table 20: Survey Results for Subborrower SMEs (216 sample) Time of Loan Estimated Application Time of Annual Average (Apr 2017–Mar Survey Increase Item Loan Size 2018) (Mar 2019) (%) All (216): 6,201 Average Annual Turnover (SLRs thousand) 80,756 86,146 6.7 Average Annual Profit (SLRs thousand) 8,115 9,094 12.0 Average Number of Employees 15.0 18.0 20.0

Micro (136): 4,199 Average Annual Turnover (SLRs thousand) 30,658 35,379 15.4 Average Annual Profit (SLRs thousand) 4,488 5,186 15.6 Average Number of Employees 4.3 5.4 25.6

Small and Medium (80): 9,537 Average Annual Turnover (SLRs thousand) 164,252 170,132 3.6 Average Annual Profit (SLRs thousand) 14,160 15,607 10.2 Average Number of Employees 32.6 38.2 17.2 Micro-T (85): 2,210 Average Annual Turnover (SLRs thousand) 5,638 7,009 24.3 Average Annual Profit (SLRs thousand) 1,707 2,142 25.5 Average Number of Employees 3.2 4.1 28.1 Micro-T is an enterprise that has 1-10 employees and annual turnover of SLRs15 million or less. It is a subcategory of Micro. Source: ADB staff estimates.

42. According to Table 19, the Micro-T segment experienced an exponential growth in annual turnover, profitability and number of employees in that the ADB credit line contributed to an increased annual turnover and annual profit by 39% and 129%, respectively. In terms of the absolute economic value addition, there are marginal differences between the Micro-T and the Small/Medium segments as in Table 21. In fact, Small/Medium segments outperformed the Micro- T in employment generation. However, to conclude these preliminary results, it requires more rigorous evaluation for a considerable period of time.

Table 21: Incremental Economic Benefit with a SLR1 million Subloan Incremental Annual Incremental Annual Incremental Average Item Turnover Profit Number of Employees Micro-T SLRs0.62 million SLRs0.20 million 0.40 employees Small and Medium SLRs0.61 million SLRs0.16 million 0.58 employees Source: ADB staff estimates.